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Monday, May 20, 2013

The IRS 501(c)(4) Exposes Broader Flaws at the Heart of the U.S. Tax System

President Obama is shocked and angered that the IRS targeted certain
conservative organizations for special scrutiny when they applied for
501(c)(4) tax exemptions as “social welfare” organizations. Republicans
are just as shocked. The whole Washington political establishment is
shocked, just shocked, that anyone, let alone the IRS, would try to stem
the flow of political money that pours through this gaping loophole in
the federal tax system.

The campaign finance reform organization Democracy 21 has tirelessly documented abuse of the 504(c)(4) loophole by political organizations. Its president, Fred Wertheimer, is quick to agree that the IRS was wrong to single out Tea Party affiliated organizations
for scrutiny. However, Wertheimer does not suggest that the IRS should
evenhandedly rubber stamp all 501(c)(4) applications. Instead, he argues
that it should aggressively clamp down on loophole abusers of the
right, left, and center. His list of targets includes Carl Rove’s
Crossroads GPS, the pro-Obama group Priorities USA, and Americans Elect,
an organization that sought to run an independent candidate for
president in 2012.

There seems to be an informal premise, supported by past practice of
the IRS, that a self-proclaimed social welfare organization is abusing
its tax status if it spends more than half of its budget on overtly
political activities. As Wertheimer points out, the IRS does not enforce
even this generous limit.

Many 501(c)(4)s cross the 50 percent line
with impunity, and some have even registered as political parties.
However, as he recently told the Washington Post’s Dylan Mathews, the 50 percent limit, even if strictly enforced, is already too generous. According to the relevant statute, it should be zero.
Although I applaud Wertheimer’s efforts to get the IRS to obey the
law, I think his focus is far too narrow. The 501(c)(4) “social welfare”
designation is only one of many tax exemptions that needs a rethink.
The IRS code includes more than two dozen types of 501(c)
organizations, ranging from credit unions to insurance companies, that
qualify for various kinds of tax privileges.

The 501(c)(4) social welfare groups that are at the center of the
current IRS scandal are sometimes lumped together with their close
cousins, 501(c)(3) charitable organizations. They share some tax
privileges such as not having to pay tax on income they earn and
exemption from gift taxes. In other ways they differ. The big draw of
501(c)(3) status is the right of donors to deduct contributions from
their federal income taxes. The main attraction of 501(c)(4) groups,
instead, seems to be their right not to reveal the identity of their
donors. For some donors, anonymity is apparently even more valuable than
a tax deduction.

In a two part series last year [1][2],
I argued that we should eliminate the tax deductibility of
contributions to 501(c)(3)s. These are the main points I made, many of
which apply to 501(c)s of all varieties:

The ostensible justifications for 501(c) tax exemptions are “social
welfare” and “charity.” However, these organizations are not exclusively
devoted to such goals. Even for 501(c)(3)s, no more than a third of
tax-advantaged spending goes to real charity, if we use that term
according to its dictionary meaning of “generous actions or donations to
aid the poor, ill, or helpless.” For other 501(c)s, charity and social
welfare is often even more incidental to their main activities.

Even the full tax deductiblity of 501(c)(3) contributions does
little to increase overall giving. That conclusion finds support both in
statistical evidence and in the effects of past tax law changes that
have sharply cut the economic value of the deduction with little if any
impact on total giving. The idea that we would get insufficient
political giving without tax privileges for 501(c)(4)s is even less
credible.

All tax exempions are costly to the federal budget. That is why
economists refer to them as “tax expenditures.” Just for 501(c)(3)
organizations, each $1 of truly charitable spending induced by the tax
exemption costs the budget from $3 to $4.5o, depending on the estimate.
If we included tax losses from exemptions for all the 501(c)s, the ratio
would look even worse.

In any event, tax-deductible giving is only a small part of what
makes Americans the most generous people in the world. Much of that
distinction comes from our willingness to help both neighbors and
strangers on a one-to-one basis and to volunteer our time, not our
money, to charitable organizations. The same goes for politics. It is
unlikely that an end to the tax privileges and anonymity provided by
501(c)(4)s would fatally damage the democratic process or the
willingness of people to give time and money to political causes they
believe in.

Progressives and conservatives should be able to agree, although for
different reasons, that we should eliminate 501(c)s of all kinds.

Progressives tend to have faith in the ability of government to
promote social welfare and help the less fortunate. Accordingly, they
should be willing to support a reform package that closed tax loopholes,
left tax rates unchanged, and spent the resulting increase in revenue
on expansion of social welfare programs.

Conservatives tend to think that reducing tax rates is an important
policy goal in itself, and to think that the private initiatives do a
better job than government in helping the poor and undertaking other
civic initiatives. Accordingly, they should be willing to support a
package that eliminated tax preferences, used the resulting gain in
revenue to reduce marginal tax rates, and left social welfare to the
private sector.

In a rational world, progressives, conservatives, and centrists would
be able to craft a tax reform compromise that did a little of each of
the above and left us all better off.

The bottom line: The scandal over the apparent political bias in the
IRS treatment of 501(c)(4) groups is nothing compared to the broader
scandal of a tax system that is corrupt and inefficient at every turn.
We need to attack the code with an axe. In doing so, we should not to
flinch at chopping off the 501(c)s with all their rotten branches.

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